Is whole life insurance a rip-off?

By Ronald J. Pawlikowski

"Is whole life insurance a rip-off?" That is an actual question I received from a potential client, albeit many years ago. And it’s not a bad question, given the media’s treatment of whole life over the years.

When I first became involved in the life insurance industry in the early 1980s, whole life was probably at its nadir in popularity.
The first universal life insurance policy was introduced in 1979, the same year the Federal Trade Commission issued a report criticizing whole life for its below market returns. The prime rate was at 11.75 percent to start the year, and ended at 15.25 percent (and peaked at 21.5 percent in December 1980). That is not the type of environment in which whole life will shine.

If you ask a layperson (or even some insurance agents) to describe whole life, they would most likely respond by saying it’s term insurance with a savings component. But that is just an analogy; it isn’t how the product is actually constructed (although it is very
close to how a universal life policy is constructed).

The cash value of a whole life policy is actually a reserve to pay future claims, although it can function as a savings component. The guaranteed cash value schedule is on file with each state’s Department of Insurance in which the policy is offered for sale, and each issuing company guarantees it.

Back in the early 1980s, a common interest rate used to develop the guaranteed cash value was 4.5 percent. That does not mean that the cash value increased by 4.5 percent each and every year, it was just the assumptive rate used to construct the policy.

In the early 1980s, most of the largest insurance companies (Prudential, Metropolitan, John Hancock, Equitable, New York Life) were mutual companies. That means that rather than shareholders, the policyholders owned the company (similar to banks versus credit unions). Accordingly, any dividends* declared are paid to the policyholders. While the payment of dividends increases the total return of the policy, there is no way they could have increased as quickly as interest rates did at that time.

Hence, whole life lagged market returns, and was disparaged as a dinosaur by the media. Some of the criticism was warranted, as the life insurance industry was slow to respond. It wasn’t until massive disintermediation set in, whereby policyholders borrowed at a guaranteed rate (usually about 5 percent) and invested at much higher market rates, that the industry made a valid attempt to
fix the problem.
In the current environment, whole life is once again looking good. People who bought the product 10 or more years ago are now experiencing annual gains of 4 percent to 7 percent, which is very competitive for such a conservative vehicle.

So to answer the question, no, whole life is not a rip-off, but that doesn’t imply that it is a panacea either. It is the most conservative life insurance policy offered, meaning that the insurance company holds most of the risk. It should be a part of your clients' life insurance portfolio to the extent that they want to be sure a claim will be paid upon their demise, whenever that may be.

*Dividends paid by mutual life insurance companies are deemed a return of premium, rather than earnings. As such, they don’t become taxable until they exceed basis, at which time they are taxed as ordinary income.